Buffett’s Multiple

August 01, 2008

Evan Vanderveer column: Emil Lee of the Motley Fool wrote a wonderful, yet underappreciated article on which I hope to build entitled, “Is 12.5 Buffett’s Magic Number?” In short, the answer appears to be unequivocally, yes.

Warren Buffett is arguably one of the most selfless educators in business history. At the Berkshire Hathaway Annual Meeting each May, he allows shareholders to ask questions without any restrictions, except in regards to his current holdings. When asked about valuing businesses at these meetings and others with students, Buffett has responded by repeating John Burr Williams definition of intrinsic value penned in 1938; intrinsic value is all future cash flows from the company discounted at an appropriate rate. In other words, as Buffett previously said, “If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it’s worth.”

But Charlie Munger has said he has never seen Buffett compute a discounted cash flow analysis, the common practice for attempting to value a business based on the above definition. When recently asked about how he specifically calculated a company’s intrinsic value, Buffett simply laughed at the interviewer and said, “Well, that’s the secret”.

So if Buffett doesn’t use a DCF calculation to find intrinsic value, how does he do it? He has provided us some clues. The first and one of only a few times Buffett has explained his methodology was in his Buffett Partnership letter in 1958. He details “a typical situation” in which he describes investing in the Commonwealth Trust Co. of Union City, New Jersey. I will omit some of the surrounding details, but most importantly Buffett states “it has an intrinsic value of $125 per share computed on a conservative basis.”

He also told us the stock was currently trading around $50 and had “earnings of about $10 per share.” Emil Lee suggested Buffett likes to pay no more than 12.5 times earnings for good businesses. But taking the concept one step further, we can clearly see Buffett simply multiplied the company’s earnings by 12.5 (almost exactly) to calculate the intrinsic value of $125 per share. A coincidence? Possibly.

Lee quotes the following passage from Buffett’s 1991 annual letter:

Ownership of a media property could be construed as akin to owning a perpetual annuity set to grow at 6% a year. Say, next, that a discount rate of 10% was used to determine the present value of that earnings stream. One could then calculate that it was appropriate to pay a whopping $25 million for a property with current after-tax earnings of $1 million.

As Lee tabulates, “Thus, paying 12.5 times that price would be equivalent to buying a dollar for 50 cents and would provide an 8% free cash flow yield (invert 12.5) that should compound over time.” Another 12.5 multiple example.

More recently, Buffett was asked to testify about the estate tax at a Senate Finance Committee meeting. I was in attendance and heard Buffett explain the estate tax’s effect on family businesses when they are held and when they are sold. He used a newspaper company as an example, stating the company that earned $8 million a year would be sold for $100 million. $8 million times 12.5 is of course $100 million. There are likely more examples in other annual letters and meeting transcripts.

After reverse engineering some of Buffett’s more recent investments, the 12.5 (or there about) multiple often appears. Buffett was loading up on shares of Johnson & Johnson, the well-known health care company, in the first quarter of 2007, buying some the previous year, and more after. The price he paid was in the high 50’s to mid 60-dollar range. Johnson & Johnson generated $12.5 billion in free cash flow in 2007. $12.5 billion times 12.5 is $156.25 billion, or about $55.40 per share, very close or equal to what Buffett was paying.

In the Johnson & Johnson case, earnings are less than free cash flow. The implication here might be that the 12.5 multiple can be applied to both earnings and free cash flow on a case-by-case basis. The difference between free cash flow and GAAP earnings is dependent upon both the business and the accounting pertinent to the specific industry. Buffett may have used free cash flow as a metric here instead of standard earnings.

Buffett has also been adding to his already large stake in Wells Fargo recently. The firm’s current P/E ratio is 12.45.

Buffett valued PetroChina, a recent homerun, at $100 billion dollars when he began buying in 2002, while the company was trading only at $35 billion. $100 billion was about 12 times operating income.

You might be wondering, what about purchases such as Burlington Northern Santa Fe, a company that generated about $1 billion in free cash flow last year and trades at a P/E of about 20 with a forward P/E of 14.78? Neither of those numbers looks like 12.5. Well Buffett was buying in the high 70’s and low 80’s when the forward P/E was about 11.5. He stopped purchasing after the stock ran up to loftier multiples.

Don’t like the number 12.5? No problem. Other value investors use a variety of multiples to calculate intrinsic value. Mohnish Pabrai, Managing Partner of the Pabrai Investment Funds, is known for using a 10 times multiple for stable companies and a 15 times multiple for growing companies. He usually applies these multiples to free cash flow but has applied them to earnings as well.

Bruce Berkowitz, manager of the famed Fairholme Fund, recently stated he looks for a free cash flow yield of 10% or more, implying a free cash flow multiple of 10 or less.

Father and son managers Herbert and Randall Abramson of Trapeze Asset Management place multiples on earnings, operating cash flow, and free cash flow to derive intrinsic value. They study comparable companies in a specific industry in an attempt to find a fair multiple for the individual firm being valued. If for instance the team finds a Colombian E&P firm trading at 2 times 2010 projected operating cash flow and the industry average is 7 times, they consider backing up the truck.

Today, a holding company, whose majority asset is a regional bank growing at more than 25%, had earnings of $1.02 last year. The current stock price is $5.05. Using the “Buffett multiple” of 12.5, the intrinsic value is $12.75 or more than double the current stock price. A modern Commonwealth Trust Co. You get the point.

Like the story of Hansel and Gretel, the children in the forest who leave breadcrumbs on the trail to find their way back, Buffett has left investors little hints along the path to understand how he calculates intrinsic value. Now all we need to do is pick them up, digest them, and use them to find our own way to investment success.

Comments

I believe Warren would have a good laugh on that article I'd appreciate if you'd send it to him.

What you did was, taking some of Warrens purchases where - by coincidence - the 12.5 multiple applied. I'd suggest you make a statistical research by taking Warrens last 100 purchases and you'll probably end up with a lot of deviations.

Furthermore: Warren is not stupid! By stating that he would use a fixed multiple you're actually saying he cannot think on his own. I however believe him to be a very flexible thinker. He will pay a higher price the better the business gets. Nonetheless it's just natural he doesn't pay 20 times earnings for a company because intrinsic value for large caps will hardly be 40 times earnings. I'm sure though that Warren feels free to buy businesses like WFC at less than your 12 times multiple :-) - whereas I blieve he'd pay easily 15 times earnings to buy a wonderful business like Coke.

In most cases Buffett would probably use a ~12x P/E multiple because ~8% is the required equity return from an investor in a blue-chip company.

However, one should note that according to Lowenstein's biography of WEB, Buffett did buy Coca-Cola (KO) at a multiple of 20x. Clearly the man saw that the FCF yield would increase substantially in the coming years.

It appears that you are trying to value stocks solely by P/E. It's how I started as well a few years ago, but it's naive, in hindsight.

I think that "Calculating the intrinsic value" of a company involves more than just numbers. For example, it involves a deep assessment of the managers of the company. Buffett and Munger only buy companies run by managers they "like, trust and admire", or so I've read. You can't put that into a mathmatical formula. It's more "art" than "science", but it's vital to "calculating the intrinsic value".

I think that Buffett and Munger often toy with us with their words - you can see it in the above article. Example:

"If you can tell me what all of the cash in and cash out of a business will be, between now and judgment day, I can tell you, assuming I know the proper interest rate, what it’s worth."

Think really hard about the "If" side of this. Ok, I'll give you a hint. To paraphrase: "If you can give me a lever long enough, and a fixed place to stand, and I can move the world."

At the same time, however, Buffett and Munger, especially in their letters to shareholders, are constantly and generously giving us invaluable tips on how to "buy great businesses at reasonable prices". It's as if they are saying, "Wake up, America. If you'd stop reading the answers at face value, or perhaps read the answers at EXACTLY face value, you'd see that the answer is staring you right in the face. You just don't want to hear the answer, because then you'd have to do the hard, diciplined work of learning to be an "intelligent investor" (Ben Graham's meaning).

Instead of P/E, I suggest taking a closer look at P/V, Price relative to value. And, don't forget the important qualitative variables of "understanding", "sustainable competitive advantage", and "able and trustworthy managers." If one of these components is missing, it may make for a sub-optimal investment.

From Graham and Dodd to Buffett and Munger the world of value investing is a search for enduring quality at bargains. Ever wonder how Warren Buffett and Charlie Munger really "frame" an investment decision? I think you might like my new small self-published book. My book, "The Four Filters Invention of Warren Buffett and Charlie Munger" examines each of the basic steps they perform in framing and making an investment decision. Buffett mentions the Four Filters this way: "Charlie and I look for companies that have a) a business we understand; b) favorable long-term economics; c) able and trustworthy management; and d) a sensible price tag."

The Four Filters cluster around the important business variables of Products, Customer-Sustainablility, Managers, and Price/Value. The book also strives to demonstrate that Buffett and Munger invented a Behavioral Finance Formula composed of three qualitative steps and one quantitative step, that is underappreciated by the business and academic communities. In that respect, Buffett and Munger will have a greater long term impact on academics than the Efficient Market Hypothesis.

While my book is concentrated on Munger and Buffett’s approach to framing, this book contains the best of Graham, Carret, Fisher, Buffett and Munger. Read the summary a few times, and you will be motivated into thinking about ways you “frame” your important decisions.

What we view as tough times may soon be viewed as "buying opportunities" for Warren Buffett and other value investors. After all, some of their best purchases were made during the stagflationary period of the 1970's.

I think Buffett and Munger invented an amazing Behavioral Finance Formula or Process that is underappreciated by the business and academic communities.

On paper as early as the 1977 BRK annual letter, their work in designing a mixed qualitative + quantitative formula may be worthy of a Nobel Prize in Economics and Behavioral Finance. So, in my new self-published book "The Four Filters Invention of Warren Buffett and Charlie Munger" ( www.frips.com ) I examine each of the basic steps they perform in "framing and making" an investment decision. I made this book a small and focused look into this amazing invention within "Behavioral Finance."

The use of cash flow, P/E's. P/S ratios and etc. are all good if used with the right knowledge. Buffett, Berkowitz and other focus on people skills. While the numbers tell the story, it is the people who produced them over time. If you read "The Warren Buffett CEO: Secrets From the Berkshire Hathaway Managers" and biographies of Warren the secret is revealed. He is a bit manic on business and the managers are fanatics on business success where at times their families take backseat to running the businesses successfully. READ CAREFULLY and you will see this revealed. So..first and foremost business is about people skills and their focus to succeed not just to line their pockets but to leave a legacy of success by which their lives can be judged. It is almost a religion to some of them. These are the people you want to have in your investment portfolio. Today's guru's include Bruce Berkowitz, Eddie Lampert, Bill Ackman, Ian Cumming, Bruce Flatt, Bruce Rattner and quite a few others listed on this site.

Successful investing is not about finding the right formula and then taking it to an unrelated investment. It is all about running a company yourself which most of us cannot do or identifying people who can do this for us and then using a pricing mechanism to identify where to buy them cheaply and make them part of our personal portfolios. Most in my opinion believe it is about the numbers and ignore the talent. For me it is about the talent and then determining what price to pay.

Good article. I also use a simplistic P/E multiple to value companies (I use Graham's 8.5 along with extra for growth). As always, one should realistic earnings (i.e. normalized earnings). I think your article would have been stronger if you looked at normalized earnings (which may have been what was reported) and looked at more examples.

Although you are correct in saying that Buffett places great emphasis on management, that is not all there is to it. It's more complicated than that. After all, wasn't it Buffett who alluded to buying companies that any fool can run because a fool eventually will? If management mattered why would he even refer to such a concept.

If the company can compound your initial investment at a high rate of return for a long time, then it has a moat. A moat protects earnings from competing capitalists that would like to increase their share of the same. Few companies are able to hold off competitors for any length of time. Few companies can compound money at high rates. Even if it has a moat, buying at the right price is all important, like you say, or your investment is moored to poor results. Its the combination of the durable moat and the investment price that leads to investment success.

benethridge and SeekingTraceEvidence put their fingers on it. Buffett's most elusive skill is his judgment of people. This isn't something quantifiable; it comes from intuition and experience. This is a huge advantage for him in Berkshire's acquisition of wholly-owned companies, but not as much buying large, publicly-traded companies. There are small publicly-traded companies that are still run by their founding CEOs, who also retain a significant ownership stake, and plan on running their company for a long time, but that's less common in large, longstanding publicly-traded companies. So it makes less sense (if you are a buy-and-hold-forever investor) to buy a company like KO based on your opinion of the CEO, when he might not be there in 5 or 10 years.

What you did was, taking some of Warrens purchases where - by coincidence - the 12.5 multiple applied.

Exactly ! WEB and Munger know a lot about their stocks. They probably didn't know this multiple applied to their recent purchases. If you dug some more you might find that the CFO's of the companies they bought all had a 20% raise in the last 2 years. Now does this mean any company with a well rewarded CFO is a good stock to buy ?

Sorry, it was not my intent to be rough on Evan Vanderveer. At least he's TRYING to figure all this out. I was speaking more to Americans in general, in my last paragraph, because they appear to be too lazy to even try to learn the principals of sound investing, and yet with the death of the defined benefit pension plan, they are going to HAVE to...or eat cat food in retirement. Allow me to expound please:

I believe that the U.S. government and Americans in general, are "overleveraged" (on houses, credit cards, gas-guzzling SUVs, wars, housing bailouts, and on and on). I think that's part of the reason Buffett has been lately saying that Berkshire Hathaway owners can only expect to see about 7% returns over the next few years. Do you really think you can do better?

It is rapidly approaching the time when we as Americans will have to finally "pay the piper". Where are we going to come up with the money?

To correct our course, I think Buffett and Graham would tell us to (a) start running our country and our personal finances more like a well-run business and (b) evaluate stocks as BUSINESSES, and not as market commodities to be "traded" daily by the "GotRocks" and their expensive "Helpers". See his 2005 Letter to Shareholders for an excellent lecture on this:

Buffett, I'm told, keeps a copy of Ben Graham's "The Intelligent Investor" on his desk, and refers to it often, to keep himself grounded in its principles. It is not an easy read, but the copy I have, has a commentary by Jason Zweig after each chapter, which translates the message into more modern and (for me) understandable words. If we would all just follow that book plus the profound and humorously colored wisdom Buffett and Munger teach in Bershire Hathaway's annual Letters To Shareholders, we would all be much better off as investors, and America would be a much better country, in my opinion. It will be a sad day for me when these great old men die.

Yes, the numbers matter, but so do the managers. It is easy to evaluate the numbers; they're all over the internet these days. It is hard to evaluate the managers. I believe this is so because, unlike the hard numbers, most stock investors are not clamoring for the softer "management analysis". This is what frustrates me about stock investing. The best I can find is the "Stewardship Grade" and the management analysis that Morningstar (Premium Edition) provides. Unlike Buffett, I don't have lots of spare time and a Gulfstream jet in which I can fly off to various company sites and command the attention of the company CEO and its board. This, to me, is the last piece of the puzzle of investing...the frank, honest and in-depth discussion of management. Ok, the Gulfstream would be a nice piece to add, too. :-)

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